Sam Chandan: Thanks to everyone for joining today’s Roundtable discussion. The focus areas for our conversation are emerging trends in underwriting and the outlook for risk-taking in the commercial real estate finance market. Working primarily in the bank and life company lending spaces, I see fairly clear signs of a shift in underwriting standards and lenders’ growing tolerance for risk. But I suspect we will each have a unique perspective on where we are in the market cycle and the fairest way to describe current risk-taking behaviors.

Our discussion cannot ignore that historically low interest rates have been one of the defining features of the commercial real estate recovery and return to expansion. I wonder how prepared we are for an abrupt inflexion in rates, or even a slow reversion to higher underlying costs of capital. To kick things off, I would like to ask Len for Freddie Mac’s outlook on interest rates. Can you give some context for today’s discussion, Len, since we have become so inured in the post-crisis period to the availability of low cost financing?

Leonard Kiefer: Rates have been very, very low and it is somewhat surprising that they remain low. Heading into 2014, we were expecting to see rates move higher over the year. Instead, rates have been extremely flat. Looking ahead, we are not really expecting to see a lot of upward movement. As we get closer to potential tightening on the Fed Funds rate, you might see some increase in volatility in rates. But for now and for the remainder of this year, with all of the concerns internationally and concerns about the overall recovery, rates will remain low although we are getting better news recently. We do not see them rising sharply until we have a stronger economic recovery underway. Then the Fed might really start to raise rates. We do not see that happening until next year.

Sam Chandan: You hint at concerns about the overall recovery. Can we spend a moment exploring that? I think it is fair to say the slow labor market recovery, in particular, has presented a real challenge for our industry and the demand-side of the space market equation. Perhaps not in the institutional segments of the market where we have the highest quality office buildings or the largest regional malls, but when we look very broadly, a weak labor recovery has impinged on absorption. What do you see happening in that regard over the course of the next year or two?

Leonard Kiefer: Yes, the labor market. Earlier in the year we were adding over 200,000 jobs per month, then things slowed down a bit in the August data. It was disappointing that we only had 142,000 net new jobs in August but we should not make too much of those month-to-month numbers. There are always revisions.

Overall, I think that the underlying labor market trends actually show some strengthening. Even though nationally the unemployment rate is about 6.1 percent, which is not far off from a long-run average rate, other indicators such as long-term unemployment, part-time work, participation rates, and wage growth to name a few, speak of a relatively weak labor market. But we are seeing things firm up and our tracking data on third quarter economic growth in particular looks pretty good.

We had a solid second quarter, and we expect the fourth quarter to be pretty good as well so things will start to firm up. But it is going to take a while; it is going to be a grind, especially in the jobs arena. It is probably going to be a year and a half before the headline unemployment rate falls well below 6.0 percent. It might bounce around if labor force participation moves but we see things picking up. That is badly needed, particularly if you look at the younger age demographic including 25 to 34 year olds.

Sam Chandan: The persistence of a slow but improving job recovery suggests limited wage pressures. Should we expect little in the way of inflation?

Leonard Kiefer: A higher rate of inflation could happen. But if you look at overall growth and the global situation, that will dampen things again. So I do not see inflation really taking off. On the other hand, and independent of an uptick in inflation, some may say we will see interest rates spike and rise very quickly. I actually do not think that is likely to happen. I think you will see a lot of volatility, and that rates may spike significantly around policy announcements, or just around speculation of those announcements, and then I think things will settle back down and it will be a more gradual adjustment until we back into higher rates over the next three to four years.

Sam Chandan: Peter, from your vantage at Cantor, what is the market expecting in the interest rate environment over the next couple of years?

Peter Scola: I generally agree with everything that Len has said. A couple of things I would like to add. First, as far as interest rates are concerned, I believe we are cheap relative to other countries, particularly when you look at the fundamentals of their economies versus ours. Second, I think we’re going to be in a historically low-rate environment for a while. I also wouldn’t be surprised if we continue to see volatility. I expect the volatility in the underlying risk-free rate will continue as everyone tries to figure out where we are going over the next few years. I’ve consistently said over the last 5 years that rates are going up, I just don’t know when.

Brian Olasov: Yes, and obviously this has been something of an obsession among lenders. But I also get a sense of interest rate shock fatigue because the pundits have been calling for interest-rate shocks now for such a long period of time that market participants are generally complacent. And I would say that one of the locations where the complacency does put the lender at risk is back in the banking sector. The banking industry has $2 trillion worth of loans that either mature or reprice after five years. That’s one-in-four loan dollars in the banking system. That doesn’t match up with the duration of liabilities in banks.

Sam Chandan: What was the process of adjustment in the market last summer when we had the big rate spike between May and July?

Peter Scola: During the first half of the year prior to the spike, people were operating in a very low-rate environment, arguably unsustainably low. All of a sudden, the market started reacting to a possible increase in rates, which resulted in volatility across the broader markets. I think the market’s reaction spooked people for a while, especially as we all continue to adjust to a seemingly new normal.

Sam Chandan: If less accommodative Fed policy and higher long-term rates both coincide with a stronger economy, we should see the demand side of fundamentals improving in a way that will offset at least some of the capital drag on values. But apart from the market’s cyclical features, the fundamentals equation is also in flux, albeit in ways that are more subtle. In the way we use office space, for example.

Kim Diamond: I think there are shifts that will impact the office sector: how we use and configure office space and what that implies for office space demand. There are so many people with alternative work arrangements now, so much consolidation.

Sam Chandan: Kim, that’s really interesting. One of the things I’ve seen in the recent research is that for professionals, its not so much that the availability of technologies and alternative work arrangements are allowing us to forgo a desk at the office altogether. It’s more that the technologies are allowing us to continue working every evening and weekend, after we leave the office. But to your point, there are significant changes in the relationship between office-using employment and the number of square feet that we are absorbing in the market. Are you seeing some of these broader changes show up in underwriting?

Kim Diamond: I think there are hints of these changes that we are seeing. For example, there are many office properties with tenants that have historically occupied large blocks of space and are now subleasing portions of it. We are also seeing changes in the way retail space is being used such as the reconfiguration of space that used to be occupied by traditional anchor stores into more inline space. So there are definitely trends. I mean look, we went through this a decade ago when everybody was concerned that catalog shopping would replace in-person shopping. Now people are saying Internet shopping will replace in-person shopping. I don’t think that it’s that black and white but that could be a reason, for example, why a lot of malls have added entertainment components-both to draw people there in the first place and keep them there longer.

Sam Chandan: When you listen in on some of the REIT investor calls, they are talking about the mall as a lifestyle venue, above and beyond a place to shop. Does that reflect the repositioning that you are describing?

Kim Diamond: Keep in mind that there are a lot of non-major metropolitan areas in this country where the local mall serves as the center or focal point of the community.

Sam Chandan: One more question about property fundamentals before we move to lending and risk taking and where we are in that risk tolerance cycle. David, some of the data that I’ve seen over the last couple of months points to stronger multifamily fundamentals than I would have anticipated at this point, particularly with new inventory coming online. Are your numbers showing something similar? Is the apartment sector continuing to outperform?

David Brickman: It is. It is doing that as completions and supply are increasing. Indeed, we continue to be very bullish on the outlook in part because of the strong demand drivers that continue to fuel rental demand. In fact the historical notion that 300,000 or so units of multifamily is the steady-state is perhaps an obsolete notion post-crisis, given various changes in both demographics, credit tightness, single family market, shifting preferences, and last but certainly not least, new urbanism. Indeed the market performance coincides with some of the same developments you’ve touched on in terms of retail and office work that are all driving multifamily and we’re likely to see continued elevated levels of new demand that will more than match the level of supply that we see in the near term. Rent increases do have to moderate. There is a friction with overall income levels and to return to where we started the conversation in terms of the macroeconomics, income growth has not been sufficient to support the level of rent increases we’re seeing so that’s going to create a little bit more tension going forward but we continue to see strong growth in the apartment sector and indeed strong capital flows broadly in the multifamily space.

Sam Chandan: Regarding those capital flows, how do you feel about where we are in the pricing cycle right now? Some market participants are clearly concerned about the kind of cap rates and debt yields that we’re seeing in the apartment sector at this point. Are you comfortable that we are going to see gains in income over the next couple of years that are consistent with today’s pricing?

David Brickman: My guess is that most of the complaints about pricing are coming from people who are looking to buy.

[ laughter ]

Sam Chandan: Very fair, yes.

David Brickman: Indeed, everyone just shakes their head but prices are prices. I think they represent the environment we’re in. Certainly I don’t think there is any evidence of a bubble so we can rule that out. The question then is do the prices fairly represent supply and demand fundamentals? I think so. Are they influenced by the low level of rates? Absolutely, and so to the extent that the question is if interest rates increase could that affect pricing? Yes, it could and would but I do think that most of what is driving pricing in multifamily is the stability of the asset class, the continued growth in rents that we’re likely to see, and the financing market that we’re in.

Sam Chandan: To that point, how is it that we might assess a priori the degree of price sensitivity to changes in the interest rate environment? Are there parts of the multifamily market that might end up being more sensitive to interest rate changes than others? My team has done some work in this area but the findings are not conclusive.

David Brickman: That’s a great question and yes. I think you have a good debate as to which should be more sensitive. The observation has generally been the lower the quality, so B and then C, the greater the sensitivity to interest rates. That’s primarily an empirical observation based on last year’s Fed induced experiment with rates going up and we saw the greatest movement in the B and C space and the least movement in the A space in terms of cap rates although cap rates ultimately came back in to their levels prior to the run-up. I would only add though that I’m not sure that if there were a larger, more permanent change in rates that would necessarily be the case. I might expect that at some point when the rate increase is larger we might expect that those assets that are ‘priced to perfection’ in terms of where incomes and rents are going to be in the A class space, and they may actually experience equal or possibly greater price movements. But again, so far facts suggest that B and C tend to have that greater sensitivity.

David Durning: There are parts of the market that are in a dangerous zone. I would say by and large what life insurance companies are doing provides them with sufficient cushion given the interest rate levels. If Treasury rates increase 200 or 300 basis points, we think that the loans being underwritten today handle rates at those levels on the life insurance side. When I look at the market more broadly, yes, we are concerned with low debt yields, shortness of maturity and lack of amortization, and we would expect that there would be some excitement when those loans mature and have to be refinanced.

Brian Olasov: We’ve seen through half year 2014 60% of CMBS loans have some partial or full-term IO and that’s definitely an uptick over previous years. The obvious point though is to ask what’s happened with leverage. If you have increasing loan-to-value at the same time that you have increasing use of full term IO, then balloon default increases. But we haven’t really seen that combination yet.

Sam Chandan: We have a real mix of opinions on underwriting broadly. For every article in the press describing how people are concerned about deteriorating underwriting standards, whether in the CMBS market or commercial real estate as a whole, you have a whole other group of folks saying we don’t have significant deterioration, at least not to a degree that we should be concerned. Instead they will argue that we have a process of normalization in underwriting standards after a crisis period during which lenders have been unusually conservative. Where do you see us in that cycle? How would you characterize the quality of underwriting today?

Brian Olasov: There are so many anecdotal observations and obviously the conventional wisdom is to believe that underwriting has declined. But if you take a look at CMBS in particular, because that’s where we have objective data, there’s strong evidence to the contrary. If you take a look at debt yield or if you take a look at risk premium over treasury rates, for example, or if you take a look at loan-to-values, or debt service coverage ratios, we really haven’t deteriorated all that much from 2011 levels. Two thousand and ten was anomalous because we were just coming out of the Great Recession. More importantly, even where we’ve had declines in underwriting on the underlying properties, the rating agencies have actually done a pretty good job of reacting to that by increasing subordination levels. Triple B support levels are double what they were in 2007.

David Durning: The overall premise of normalization is probably where I would fall. Within the past year, momentum has continued to shift in favor of borrowers. That has meant that there has been slippage in underwriting, more so in the CMBS space than in what we see in our portfolio loan business. Overall, there is just more pressure. From a historical perspective, we look at key metrics, and view today’s underwriting as still acceptable and attractive, versus historic norms, especially in light of strengthening real estate fundamentals that we are seeing. We agree that we are not at 2006-2007 levels. We feel pretty good about the loans we are making now. As you reflect upon what has happened over the last 12 to 18 months, it is a trend line that, if not altered, leads to a place that is 2006-2007.

Kim Diamond: From our perspective, I would say we’ve definitely seen deterioration. I wouldn’t say that it’s been a precipitous change but rather a slow creep, and I don’t think that we’re in a danger zone at the moment but I fear that we might be if we keep following the current trend line. In the 2.5 years that KBRA has been rating conduits, we’ve seen average pool LTVs on our numbers migrate from about 90 percent to over 100 percent in recent deals. And looking at leverage alone understates the deterioration because we’ve also seen an increase in the use of IO structures. Full term IO is now at approximately 20 percent on average, up from 5 percent in 2012 and partial term IO is at approximately 40 percent up from 20 percent in 2012. In addition to the increase in leverage and IO, we’ve seen a large number of significant sponsor cash outs and we’ve seen some deterioration in structure like reserves that aren’t funded until a specific trigger event occurs as opposed to being funded up-front or reserves that are capped. The good news is that we have not yet seen a full-blown return to pro-forma underwriting. Mostly we’re still seeing cash flow in place, but we’re seeing some signs of deterioration here as well like rent averaging for non-credit tenants or credit being given for LOIs as opposed to signed leases. Again, I think we’re ok for now, but I would say that having roughly 40 conduit loan originators competing for business doesn’t bode well for the future.

Sam Chandan: You mention the increase in the share of IO in the market and the increase in loan-to-value ratios. Clarify for me, when you mention those LTV numbers, those would be Kroll’s KLTVs?

Kim Diamond: Yes.

Sam Chandan: And when we have less amortization, maybe the loan sizes get a little bit smaller. But that doesn’t sound like what you’re describing. Do you see offsets to the riskier loan structures?

Kim Diamond: Not really. In fact, rather than smaller loan sizes, I think we’re seeing an increase in overall loan size especially when you consider additional financing. Most of the time the additional financing is in the form of mezzanine debt as opposed to other forms of debt that are not quite as innocuous; however, I don’t see a whole lot of compensatory factors truthfully.

Peter Scola: This will be a shocker, Kim, but I think I have to disagree with you.

[ laughter ]

At CCRE, we take a very real estate specific approach when analyzing deals. To me, a ten-year IO loan on a 55 percent or 65 percent loan-to-value (LTV) or high debt yield, has a different risk profile than a 10 year IO loan on a 75 percent or 80 percent LTV. I think people would have vastly different opinions of those 2 examples based solely on those high level statistics. I think you have to go back to where you believe we are in the real estate cycle and whether you believe the economy has room to grow and improve. Assuming we’re not at the peak, one could extrapolate, and granted these are all macro extrapolations, that rental markets will continue to improve, occupancies will increase and leasing momentum and rates can improve. I think we’re at a point in the cycle where a lot of people believe that overall growth has a more upward bias than downward bias. If you believe what I just went through, credit performance should improve.

As for cash-outs, we review these deals on a case-by-case basis. For borrowers that have owned a property for 10-15 years, have managed through different cycles, have invested capital and increased value, cash-out refis seem to be very supportable. When you create value, you’re supposed to be able to benefit from it. Overall, there are just a lot of both macro and micro factors you have to dig into when reviewing each deal. At CCRE, we take a very real estate specific and sponsor-specific approach and we really try to dig into each individual underwriting. Often an issuer’s approach and metrics differ from the rating agencies particularly in terms of cap rates, where rating agency cap rates are set at levels that even in the downturn weren’t consistent for a long period of time. They tend to be extremely high and therefore generate valuations that result in high LTVs that are not consistent with where properties are trading in the market.

Kim Diamond: I completely agree with everything you’re saying. There’s no question about it. It is very, very case specific. I would say that for every example of what you’re citing, while those do exist, there is a preponderance of examples where that discipline is not being applied.

David Brickman: If I could jump in on this question of our position in the underwriting cycle, I might be a little in the middle of these two views. I would agree with much of what Peter said in terms of the environment. We also can point to observable, factually precise loan attributes that while looser are not unreasonable in the current environment. I am thinking of things like the amount of IO or leverage levels. We can assess those based on the economic environment and point to rational reasons why they are supported by the current real estate environment. I think what concerns me though, going the other direction, are the more qualitative factors; the ones that don’t get picked up as readily in any model or analysis. I think both Peter and Kim are touching on them, the quality of the income being underwritten. I think when we look at what went wrong pre-crisis, certainly that’s what we circle, poor quality or pro-forma underwriting. I think there is in our mind looking at multi-family and deals done away from us, there is clearly a degree of wishful thinking in some of the underwriting that is going on. It’ not misrepresentation, it’s not fraud, if you will, but there is clearly some degree of excess optimism in underwriting that is occurring which is the first step down that path that we think is more problematic.

Certainly people choose to put more or less leverage on, I think that’s more of an economic choice, but we do want to be careful about maintaining the same standards about how we assess income. Other attributes relate to loan structure, if you will, guarantors, Kim touched on reserves, and funded reserves and escrows, other loan attributes more related to the qualitative aspects of the loan we see as slipping in a more material fashion. Then lastly, in terms of quality, I don’t know if the quality of sponsors or quality of real estate is any different today than before so much as we notice that there seems to be a lesser reliance on the quality of the sponsor and real estate in making some of these very same qualitative decisions that’s there was in the last couple of years.

Sam Chandan: Brian, How do you see our move to non-core property types, secondary markets, and less emphasis on sponsorship? Do you see risk taking along any of those dimensions?

Brian Olasov: Absolutely. I actually consider that to be a somewhat healthy development. I describe that as the democratization of credit. Large institutional, low leverage lenders and strong sponsors moved into the gateway cities and trophy properties. That was an inevitable consequence of the shock that we all suffered through the Great Recession. So you expect that investors are going to move from liquid to less liquid markets. And with that compromise, the give-up in moving to secondary and tertiary cities is decreased liquidity. And if the pricing is rational, as you lose liquidity, you pick up yield and we’ve definitely seen that. What we haven’t seen during this rebound, is a strong snapback of new construction. The little bit of construction lending going on has really been focused on multifamily and there are some pretty unique demographic reasons that may justify the movement into construction and development for multifamily.

Sam Chandan: Do these shifts have parallels on the equity side of the business? Are there still segments of the markets that are still starved for capital or have we put that behind us now? Or is it rather the opposite, that we have segments of the markets that are saturated?

Peter Scola: I don’t think the word ‘starved’ necessarily applies anymore. I think you have a lot of different equity sources. I often hear about equity investors wanting to deploy capital in only gateway markets. They all want New York, San Francisco, Los Angeles, and Washington, DC. This has created a situation where these primary markets seem saturated and buyers aren’t able to achieve their now unrealistic return expectations. If it is in the U.S., frankly I think if it’s in other major cities around the world, there’s a big pull towards real estate.

Kim Diamond: I agree with Peter. I also think that it’s not only a question of property type but also that most of what is showing up in deals these days is very complicated stuff. You’ve got condo interests, you’ve got ground lease financings, you’ve got specialty use properties like water parks and you’re seeing capital availability for even the most complicated or off the run asset classes in a lot of instances.

David Brickman: I point to as a good case study the single-family rental space which didn’t exist a few years ago. We identified it early on as an area where there’s a need for capital. Sure enough, now there is a reasonably, well-developed method of financing and capital is flowing through that space so I don’t think a shortage or scarcity of capital is a problem in really any corner. It’s just more challenging to get into than others.

Sam Chandan: Where are we with the single-family rental opportunity? Was that a cyclical play that’s run its course now that house prices are up?

David Brickman: I do not think it was a cyclical play. There is a longer-term business opportunity. I don’t think it’s as attractive, the money that got in early earned returns that will not be seen again but the notion of being able to operate a platform based on income like any other income producing property is real and it is still out there. It’s probably just smaller when house prices recovered than it was when they were depressed.

Kim Diamond: Also there are two segments to that marketplace. That’s a market that is very highly fragmented. It’s not too dissimilar from self-storage where you have a couple of very large, institutional owners, and then you’ve got a lot of smaller, regional owners, and mom-and-pops. A lot of the deals that got done initially were deals that were done by the large institutional owners but there are lending operations that are being set up for the purposes of making loans to the smaller borrowers. Not too dissimilar from commercial conduit lending.

Sam Chandan: David, Prudential has been more active in construction lending. How much of that activity right now are you engaging in the multifamily sector; are you reaching out to other property types? From a construction lending perspective, how are you thinking about the other property types?

David Durning: Our construction lending is almost exclusively focused on multifamily properties. Selectively, we will finance construction on other property types where pre-leasing, low basis, sponsorship skill and financial wherewithal, or other factors, make the loan attractive. Also, our construction loan activity is focused on owners seeking a longer-term hold combined with a longer-term fixed rate loan.

Sam Chandan: Would it be fair say that your team is watching construction levels in multifamily very closely?

David Durning: Yes, and there are markets today where we are comfortable with our current construction lending activity, but would be selective in adding to that exposure. A life company program is different from traditional construction lenders in the sense that we are looking for someone who wants a long-term hold, combined with a fixed rate of interest. Also, most of our construction loans would have an element of amortization at some point during their term structure. Our view is that we are financing projects that will compete well in their market and will lease at least to market levels. Once the property has stabilized, we anticipate that our lending exposure will be attractive, versus loans being made on stabilized apartments.

Sam Chandan: Let’s talk about the degree of competition that the conduit may be facing from some segments of the bank lenders. Peter, how would you describe the competitive environment amongst the lenders having changed over the last year?

Peter Scola: There are approximately 40 conduits in the market, with most of the market share concentrated in the top 10 lenders for the most part. The reality is that CMBS lenders not only face competition from each other, but also from local banks and life insurance companies, both of which have been willing to increase their leverage profile for certain assets.

Sam Chandan: Are we underpricing that risk?

Peter Scola: I don’t know if institutions are underpricing it. I assume they are pricing it for a model that works for them. But I think that is one of the results of being in a lower yield environment.

David Brickman: I would add from our perspective, and I believe that you can probably generalize this to an agency perspective, when we think about who we compete with in aggregate, it is probably first and foremost banks, then life insurance companies and lastly conduits. The banks have also been the biggest variable in that dynamic having increased their share most significantly over the last few years. The life companies have been relatively stable in their share of the multi-family space, and conduits having grown a little bit. It is the banks that have really moved the needle as I think Peter was indicating, we try to break that out into major commercial banks versus local and regional. It seems more varied on the local and regional side than on the major commercial bank side.

David Durning: A few things come to mind here. The overall recoveries in the capital markets and real estate fundamentals have greatly diminished risk levels in lender portfolios to the point that portfolios are now able to take on more risk generally. This has occurred at a time when portfolio demand for new investments is very strong, as strong as it has ever been as an industry in my memory; while risk adjusted returns have declined. Our response to this dynamic, versus where we were a few years ago, is to increase our focus and activity on structured lending, loans secured by un-stabilized apartment properties, construction loans, specialty property types, and loans in recognized global cities outside of the US. Currently we have approximately $1.5 billion exposure to properties that are either being newly constructed or where leasing has not reached stabilized levels. This activity is both complementary to our core fixed rate lending programs, and an offset to core lending opportunities in the market today that we no longer find attractive at current spreads given term-length interest only periods and relatively low expected debt yields.

Sam Chandan: How do expectations change if we see a significant, perhaps unexpectedly large, increase in interest rates? If rates do begin to trend higher, maybe even a little bit sooner than we anticipate in our baseline, does that change the equation for refis?

Kim Diamond: It changes the equation for some.

Peter Scola: All depends on the actual numbers and how big of an increase. I think a significant long-term rate increase can certainly be problematic for certain owners. I would agree with all of the previous comments about capital availability, and certainly the capital availability to help fill the capital gap on some of the assets that previously were or are still distressed.

Sam Chandan: With respect to the multifamily sector in particular, how are you thinking about some of those exit risks around, not the loans from pre-crisis that may still be lingering, but today’s originations that are made at these historically low rates but that will inevitably come back to market in an environment of higher rates as compared to a year or two years ago, more limited amortization?

David Brickman: We see that as probably the biggest risk we have. We certainly think that loans we do today, the ones we have done over the last few years are going to mature in a higher rate environment. We think very much about what the leverage will look like at that point in time in the future. It is overly simplistic to just talk about IO versus no IO. It is a matter of what you think that leverage will be for that asset given the maturity, and given the leverage put on it today. We spend a lot of time thinking about how to size the loan, not just for today and the cash flows today, but so it can be refinanced at a point in the future. Fortunately, in multifamily, per my earlier comment, we continue to believe there are strong fundamentals that will fuel income growth, but against that backdrop, there is no substitute for ensuring you have a prudent leverage level at maturity.

David Durning: I think overall that is exactly right. Our going-in debt yields and our exit debt yields are not as strong as they’ve been. We have talked about current underwriting, combined with longer interest-only periods, limited amortization, and as you said, continued robust valuations. Clearly, some caution is in order. We try to mitigate these risks by looking at debt-yield and our own internal underwritten cap rates. I think the question that we keep asking ourselves is, on an absolute basis, are the loans that we are seeing still attractive. Today, we feel pretty good about the loans we are making, but we can imagine a time going forward based on current trends when credit metrics move beyond what we think are prudent levels.

Sam Chandan: Brian, are we underpricing the risk of higher interest rates at exit for today’s new originations?

Brian Olasov: I would deem that to be a bigger potential problem than credit risk since we’re likely to be at the tail end of a thirty-year bull run in interest rates. And again, I think that the sector most at risk may be in the banks that are holding these long-term fixed-rate assets without being match-funded. Having said that, the cost of funds in banks right now is at a level, around 25 basis points, that capital markets or even life companies can’t compete. So when you see those pricing aberrations coming from aggressive bank lenders, you do have to keep in mind that they have a built in funding advantage, which is a unique advantage. Nobody else but the government can compete with a bank’s cost of funds.

Sam Chandan: What about some of the smaller bank lenders in the market that have their share of the multi-family pie but lack the analytical sophistication of a Freddie Mac? When we are talking to some of the community and regional banks, small regionals in particular, there is sometimes a vastly different approach to thinking about the riskiness of the loans they are making, Are you satisfied that the market is thinking carefully enough about some of those exit risks?

David Brickman: No, not entirely. We scratch our heads at times, again focusing on the local and regional banks. We obviously do not have insight into their internal models nor do we have insight into their own asset liability management practices. But it strikes us that they may have issues if you do have a significant rise in interest rates. Unfortunately again, I cannot know exactly how they look at it, but the aggressiveness we see does surprise us at times from that sector.

Brian Olasov: I think some banks may have entered into a devil’s bargain where they are willing to trade off tomorrow’s interest rate risk for current earnings. If you’re putting on 10 year, fixed rate paper, even at a low leverage point, at 3.5 percent, which is where some of the loans that are being closed are that I’ve seen, even if you’re being funded at a very low cost, you still have significant overhead to take care of. And it’s not clear to me that that’s a prudent pricing position, even if the loan doesn’t constitute a more immediate default risk. I’m old enough to remember that interest rate risk, writ large, sunk the thrift industry, because of shrinking and then negative net interest margins. We won’t see that again, but it could be painful for some unhedged institutions.

Sam Chandan: A closing question for Kim about a very current issue in the market. I hear that some issuers are actively shopping for ratings. Is that once again a feature of the market?

Kim Diamond: Absolutely. I would say that the issuers are doing exactly what they get paid to do, which is to maximize their execution and unfortunately rating shopping is one piece of that. It may benefit them in the short run but in the long term it could be deadly for the market. There is nothing in the way that this business is done that has fundamentally changed post-crisis.

Sam Chandan: A sobering reminder that we still have some work to do. That’s all the time I’m allowed for today. Thank you all once again for your time and insights.